Outlook on the Future Market Development

Outlook on the Future Market Development

Page 95 of 118

Outlook on the Future Market Development

Page 96 of 118 In table 6-1 we have gathered information on price, earnings dividends and book value for the S&P 500 index, and information regarding the treasury rates on 10-year US government bonds. The information dates back to 1990, where we have divided the 26 years into five year deciles. We further illustrate the high and low prices of the index during the five-year deciles in panel C.

Table 6-1:

Table 6-1 presents statistics for the S&P 500 index at five different times between 1990 to 2016. Panel A presents the observed price level, earnings, dividends and book value for the S&P 500 index, and Panel B presents ratios computed from these statistics. Panel C shows the high and low prices of the S&P 500 index in USD during five time intervals between 1990-2016. Source: Bloomberg.

Panel A: Stock and bond characteristics 1990 1995 2000 2005 2010 2016 Closing price 330,22 615,93 1.320,28 1.248,29 1.257,64 2.238,83

Earnings in year 21,61 34,60 54,77 73,81 81,56 108,59

Average earnings of last 3 years 22,81 28,55 49,51 65,61 64,65 109,79 Dividends per share in year 11,82 13,65 16,23 22,16 22,68 45,55

10Y US treasury rate 8,07% 5,57% 5,11% 4,39% 3,29% 2,44%

Weighted book value 178,49 210,38 327,99 456,56 578,38 763,66

Panel B: Ratios 1990 1995 2000 2005 2010 2016

Price/Last years’ earnings 15,28x 17,80x 24,11x 16,91x 15,42x 20,62x Price/3-year’s earnings 14,48x 21,57x 26,67x 19,03x 19,45x 20,39x 3-years’earnings yield 6,91% 4,64% 3,75% 5,26% 5,14% 4,90%

Dividend yield 3,58% 2,22% 1,23% 1,78% 1,80% 2,03%

Stock-earnings yield / bond yield 0,86x 0,83x 0,73x 1,20x 1,56x 2,01x Dividend yield / bond yield 0,44x 0,40x 0,24x 0,40x 0,55x 0,83x Earnings / book value 12,78% 13,57% 15,10% 14,37% 11,18% 14,38%

Panel C: S&P 500 1990-1994 1995-1999 2000-2004 2005-2009 2010-2016

High price 446,45 1.469,25 1.320,28 1.468,36 2.238,83

Low price 330,25 615,93 879,82 903,25 1.257,6

As seen from table 6-1, the S&P 500 trades at the highest price in end 2016, when compared to the previous 26 years. Since 1990, the price have increased with 578%. Similarly, the earnings per share reaches the highest peak in 2016, with 108,59 compared to 21,61 in 1990. To increase the robustness of the analysis we base our results on the average earnings per share over the last three years to prevent any significant outliers to interrupt the results.

When comparing it to the levels of the 1990’s we find that the 3Y average price/earnings-ratio today is much higher than in the early bull market of the 1990’s with a ratio of 20,39 today, compared to 14,48 in 1990. It is about the same level as in 1995, a few years before the beginning of the dot-com

Outlook on the Future Market Development

Page 97 of 118 bubble, and much lower than at the peak of the bubble in 2000. Interestingly however, the ratio today is larger than in 2005 where the market was advancing from the aftermath of the dot-com bubble. The market price did advance from USD 1.248,29 in 2005, to a peak of USD 1.468.36 between 2005-2009, before the market once again went down due to the collapse of mortgage bond market. As the 3Y average P/E ratio today is much higher than at the beginning of the 1990’s bull market, and at the same levels as the years just before the financial crisis, it could indicate that dangerous times are ahead. This is further strengthened by the fact that the index currently trades close to an all-time high.

However, the picture changes when taking the interest rate of US government bonds into account.

The interest rate on 10-year treasury bonds have been steadily declining, on average, since 1990 until 2016. In 1990 the yearly interest rate was at 8,07% compared to todays 2,44%, significantly reducing the attractiveness of the yield on bonds. In 1995, before the dot-com bubble, the earnings/bond yield was 0,83, indicating that the yield on 10-year US treasury was more favorable than the earnings yield on stocks. Compared to the yield from dividends, the market was even more in favor of bonds, as bonds yielded more than twice the return that investors could generate through dividends. As the market soared, the numbers was even more in favor of bonds in 2000. Just before the collapse of the dot-com bubble in 2000, the interest rate was 5,11% on the 10-year US treasury, compared to a dividend yield of 1,23% and three-year earnings yield of 3,75% for stocks. The yield on bonds was four times higher than the yield received from dividends, and the yield on stock earnings was only 73% of the bond yield. The fact that the yield ratios favored bonds to a large extent in 2000 should have warned the investor to be cautious of the extreme price increases experienced in the equity markets during 1999/00. As Graham examined the 1959 markets, he concluded that the extreme price increases experienced at the time was signaling a dangerous time ahead, as he couldn’t believe a future market with no serious losses at that price level. The same conclusion could have been drawn from the price levels of 2000. Looking back, it was foolish to believe that the price could keep on advancing at the same pace without incurring any serious losses in the future. Between 1995 and 2000, the price of the S&P 500 index increased with 114%, whereas the earnings only increased by 58%, a sign of a heated market. Compared to 1990-1995 the price of the S&P 500 increased 87%, and earnings increased 60%. In 2000-2005 the numbers were –5% for the price and 35% for earnings, compared to 1% and 11% between 2005-2010. In the last six years, the price of the index has increased with 78%, followed by a 33% increase in earnings. The fact that the spread between growth in price and earnings is advancing towards the level of 2000, increases the suspicion of difficult times ahead. The market price has increased rapidly during the recovery from the financial crisis, and citing

Outlook on the Future Market Development

Page 98 of 118 Grahams 1959 analysis, it seems unrealistic that the prices can continue to increase without declining in the future. However, compared to the times before the dot-com bubble and financial crisis, the interest rates have declined to such a low level today, that the earnings and dividend yield compared to bond yield has never been more in favor of stocks since 1990. Due to the low interest rate received on 10-year US treasury bonds, the earnings yield is twice as high, and dividend yield 83% of the interest received on the treasuries. We believe that these prospect for equities offset the fact that the three-year average price/earnings ratio today is 20% higher than the level of 2005, before the financial crisis occurred. Even though the index trades at an all-time high, earnings are still increasing and bonds do not offer an attractive investment opportunity when looking only at the offered yield.

As the only central bank in the world, the Fed has begun to tighten its monetary policy by introducing increases in the short-term interest rates. According to Nordea’s 2017 Q1 economic outlook, the consensus in the market is expectations towards three interest rate hikes in 2017. The American economy is currently operating at close to full capacity, and the consensus are that the economy will grow approximately 2,2% in 2017 and 2,3% in 2018, according to Nordea’s economic outlook. This growth is primarily driven by a rising private consumption and business investments. As the capacity is close to fully utilized, an increasing demand in the US economy increases the risk of an accelerating inflation. As President Trump at the same time plans increased government spending, the risk increases even further. If inflation accelerates quicker than anticipated, the Fed could be forced to speed up the interest rate hikes, which would put pressure on the stock market. The Fed has indeed proclaimed that it is willing to speed up the rate in which the interest rate is raised, if inflation starts to accelerate. As there is still a large uncertainty present regarding the current administrations fiscal policy, the future development in the interest rates is still uncertain. Investors in the US markets today should be cautious about the current price level of the stocks. More defensive policies towards investments than required previous years could prove preferable in the future, although an equity investment still offers better prospects than a corresponding bond investment.

The future developments in the markets is not only increasingly uncertain in the US markets. In the European markets stock indices are reaching records heights as well. Whereas the Fed is currently tightening its monetary policy, ECB is expanding the monetary policy in Europe, with aggressively buying bonds to keep interest rates low. Although that the US and global markets are experiencing increasing uncertainty, mainly from political decisions, the VIX index for S&P 500 is trading at 16, which is the same level as in 2012, and lower than 1996-2004 and 2007-2013, which includes the

Outlook on the Future Market Development

Page 99 of 118 volatility of the markets before and after a market collapse. The VIX index measures the volatility in the market, and proxies the uncertainty and fear amongst investors. The level today indicates that little uncertainty about the current price level is present amongst investors, when compared to the historical price levels.

To sum up the analysis of this chapter, we present a recommendation for investors on which of our value portfolios we believe to be the better choice in the future. The S&P 500 index have been increasing for a long time, reaching new heights. Combined with the loose monetary policies exhibited after the financial crisis it does increase the danger of an overheated economy. The low interest rates have carried the financial markets upwards, but with the record high stock prices and Fed’s interest rate increases, the future does present the possibility of a price decline. As of now, equities represent a much more favorable investment opportunity than US treasuries, when measured on earnings and dividend yield compared to bond yield. However, the record high prices increase the potential downside, and as the current price level is currently carried by the low interest rates, prices could decline if the interest rate increases sharply. Our previous analysis of the portfolios performance under different states of the economy showed that the value-quality performed best under a contracting economy and best of all under recession measured on Sharpe ratios, whereas value-momentum performed better under a recovering and expanding economy. According to our model, the economy has been operating primarily in an expanding state the last year. This is in favor of the value-momentum strategy. However, due to the record high prices and uncertainty regarding the fiscal policy of the new US government, we call for a slightly more defensive approach. As value-quality yielded the highest Sharpe ratios during economic contractions and recessions previously, we believe this investment option could be beneficial for investors in the future. This portfolio does not yield an attractive Sharpe ratio under the current economic state compared to value-momentum and the US market index, but due to its more defensive nature, it protects the investor against serious losses if the interest rates increase more than expected and equity prices starts to decline.

As the equity market still yields a more favorable return than what can be obtained on the bond market, an investment in value-momentum could be recommendable in the short-run. Alternatively, a passive investment in the market index could be favorable, as it performs well under an expanding economy and have provided the highest Sharpe ratio compared to the value portfolios between 2010-2016, as concluded in chapter 4.10. Furthermore, it has lower transaction costs than value-momentum. The US and global economy is expected to grow in 2017 and 2018, and an investment

Outlook on the Future Market Development

Page 100 of 118 in the market could reap the full benefit of the advancing economy. However, due to the present uncertainties, we recommend that the investor does include some defensive elements in the portfolio in case of negative unexpected market movements. This recommendation is primarily driven from the fact that the current prices are record high and driven by low interest rates. If the interest starts to increase sharply, investors could experience significant losses.

Discussion

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